Professional Documents
Culture Documents
3. Is it possible for a company to show positive cash flows but be in grave trouble?
Cash flow statement only shows a company's cash position. It's not a measure of profitability. A
company can still post a loss in its daily operations but have cash available or cash inflows due to
various circumstances.
If a company has a net loss for the period and has a large depreciation expense amount added
back into the cash flow statement, the company could record positive cash flow, while
simultaneously recording a loss for the period.
4. How is it possible for a company to show positive net income but go bankrupt?
5. I buy a piece of equipment, walk me through the impact on the 3 financial statements.
Balanced sheet: PP&E account will be debited and cash account credited, increase in Fixed asset
6. Why are increases in accounts receivable a cash reduction on the cash flow statement?
Credit sales are increasing. Cash are yet to be received. Other cash outflows are going on
If the owner did not invest or withdraw, the change in owner's equity is likely to be the amount
of net income earned by the business. The revenues, expenses, gains, and losses that make up
the net income are reported on the company's income statement.
Goodwill is an intangible asset that arises when one company purchases another for a premium
value. The value of a company’s brand name, solid customer base, good customer relations,
good employee relations, and any patents or proprietary technology represent goodwill.
Goodwill is considered an intangible asset because it is not a physical asset like buildings or equipment.
The goodwill account can be found in the assets portion of a company's balance sheet.
The company recognizes the deferred tax liability on the differential between its accounting
earnings before taxes and taxable income.
Deferred tax liability is a tax that is assessed or is due for the current period but has not yet
been paid. ... A deferred tax liability records the fact the company will, in the future, pay more
income tax because of a transaction that took place during the current period, such as an
installment sale receivable
A deferred tax asset is an item on the balance sheet that results from overpayment or advance
payment of taxes.
It is the opposite of a deferred tax liability, which represents income taxes owed.
A deferred tax asset can arise when there are differences in tax rules and accounting rules or
when there is a carryover of tax losses.
Beginning in 2018, most companies can carryover a deferred tax asset indefinitely.
A deferred tax asset can conceptually be compared to rent paid in advance or refundable insurance
premiums; while the business no longer has cash on hand, it does have comparable value, and this must
be reflected in its financial statements.
European options are those options that can only be exercised at the expiry.
American options are those options that can be exercised anytime in between
The instruments will have a lognormal distribution of prices that is the value of the instrument
cannot be negative. It is only for European options. The markets are efficient and there are no
cash flows i.e. dividend paid during the life of the option. The risk-free rate and volatility are
known and are assumed to be constant.
11. Between what values does Beta Fluctuate, Can Beta be negative?
Beta is negative in case of Gold that is it moves in opposite direction of the market movement.
The Gordon Growth Model is used to determine the intrinsic value of a stock based on a future
series of dividends that grow at a constant rate. Given a dividend per share that is payable in
one year and the assumption the dividend grows at a constant rate in perpetuity, the model
solves for the present value of the infinite series of future dividends. Because the model
assumes a constant growth rate, it is generally only used for companies with stable growth rates
in dividends per share.
Sharpe Ratio the Sharpe ratio helps to study the risk-adjusted performance of a mutual fund
scheme. Technically, the ratio is defined as the excess returns of a scheme (over a risk-free rate)
divided by the standard deviation of the scheme’s returns for a given period
Sortino ratio is the statistical tool that measures the performance of the investment relative to
the downward deviation. Unlike Sharpe, it doesn't take into account the total volatility in the
investment
Treynor Ratio: - ratio is similar to the Sharpe Ratio in that it also measures the excess returns
provided by an instrument over a risk-free rate. But unlike Sharpe Ratio, which uses total risk
(SD), Treynor Ratio uses market risk, represented by beta, in the denominator. Due to the use of
beta in the calculation, this ratio is also known as reward-to-volatility ratio, since beta is the
measurement of a security’s sensitivity to market movements
Information Ratio Information Ratio, or IR, is calculated by dividing the active return (returns of
an instrument over a benchmark) by the volatility of those returns represented by TE. The IR can
test the consistency of a fund manager as it determines whether a manager has beaten the
benchmark by a large margin in a few months or by small margins every month
13. Describe the dividend Growth Model
The dividend growth model is used to calculate the fair value of equity. It can be used to analyze
that is the current value is overvalued or undervalued.
FV PV
The pecking order theory relates to a company’s capital structure in that it helps explain why
companies prefer to finance investment projects with internal financing first, debt second, and
equity last. The pecking order theory arises from information asymmetry and explains that
equity financing is the costliest and should be used as a last resort to obtain financing
Book building is the process by which an underwriter attempts to determine the price at
which an initial public offering (IPO) will be offered. The process of
price discovery involves generating and recording investor demand for shares before
arriving at an issue price
internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of
potential investments. Internal rate of return is a discount rate that makes the net present value
(NPV) of all cash flows from a particular project equal to zero.
Payback period is the measurement that tells the feasibility of the project in which it measures
the time taken to recover the cost of an investment. It is generally benchmarked with the
company standards.
Difference between Beta and alpha
Beta measures the systematic risk or the market risk of a particular stock as compared to the
market as a whole. It measures the volatility.
Depreciation generally causes a reduction on the property, plant and equipment line of a
balance sheet, though other capital assets could be affected. A percentage of the purchase price
is deducted over the course of the asset's useful life. Amortization is very similar to depreciation
in theory, but it applies to intangible assets such as patents, trademarks and licenses rather than
physical property and equipment. Capital leases are also amortized.
Depletion expense is commonly used by miners, loggers, oil and gas drillers, and other
companies engaged in natural-resource extraction. Enterprises with an economic interest in
mineral property or standing timber may recognize depletion expenses against those assets as
they are used.
Gross NPA: It is the total number of NPAs of the bank simply added.
A firm would never set out explicitly to acquire a monopoly as it is against the public interest
and illegal in most countries. Hubris is where management are overconfident about their
acquisition abilities. However, they are not aware that they are being over-confident and risking
shareholder value.
'Empire building' is where management are explicitly acting in their own interest at the expense
of the shareholder. So, in none of these cases would the reason be either legitimate or explicitly
stated
This would be a horizontal merger, as the firms are in the same industry at the same stage of
production. A vertical relationship would be between firms at different stages of the supply
chain. A conglomerate merger would be between unrelated firms, while a joint venture would
not be expected to be a permanent arrangement.
A leveraged buyout (LBO) uses a high level of gearing in order to finance the acquisition of a
target company. LBOs often accompany MBOs where managers buy out their own firm.
Additional Cash Flows from Acquisition = A+B+C-D
The pre-tax profits of the company: A
Annual depreciation: +B
Additions to profits from synergy benefits: +C
Less taxation on profits: -D
Deferred payment/earn-out involves the immediate payment of cash or shares, plus deferred
payment, contingent on the target achieving certain predetermined performance, either in
terms of sales or profits. There are many advantages to this approach, but one of the
disadvantages is the possible conflict of motives.
The reason why any acquiring company would wish to make a bid for a target company in the
first place is in principle the same reason that companies make any finance decision - to
maximize firm value. When an acquiring firm makes a bid for a target firm, the senior
management of the acquirer or bidder should be strongly convinced that the new combined
entity will represent greater value for shareholders than the sum of values for the bidder and
target taken individually.
Hubris is of course over-confidence on the part of the management which causes them to
overinvest shareholders money and make inadvisable acquisitions.
Greenmail is where the target company buys back its own shares at a premium from the
company that plans to make an acquisition.
Golden parachute is where excessively generous severance terms are built into the contracts of
senior managers to be triggered in the event of a takeover.
Scorched earth defences involve the target company making itself as unattractive as possible by
selling or destroying key assets
Operating leverage is a cost-accounting formula that measures the degree to which a firm or
project can increase operating income by increasing revenue. A business that generates sales
with a high gross margin and low variable costs has high operating leverage.
Operating leverage is a measure of how much debt a company uses to finance its ongoing
operations.
Companies with high operating leverage must cover a larger amount of fixed costs each month
regardless of whether they sell any units of product.
Low-operating-leverage companies may have high costs that vary directly with their sales but
have lower fixed costs to cover each month.
Financial Leverage
22. Cash and Carry and Reverse Cash and Carry strategy?
Cash and Carry strategy is generally used when the forward is overvalued. The forward is short
in the future.
Reverse cash and carry strategy is generally used when the forward is undervalued. The forward
is long in future.
Incremental cash flow is the additional operating cash flow that an organization receives from
taking on a new project. A positive incremental cash flow means that the company's cash
flow will increase with the acceptance of the project
Annuities are insurance contracts that promise to pay you regular income either immediately or
in the future.
You can buy an annuity with a lump sum or a series of payments.
Annuities come in three main varieties—fixed, variable, and indexed—each with its own level of
risk and payout potential.
The income you receive from an annuity is taxed at regular income tax rates, not long-term
capital gains rates, which are usually lower.
Perpetuity
Risk-neutral probabilities are probabilities of possible future outcomes which have been
adjusted for risk.
They can be used to calculate expected asset values.
These probabilities are used for figuring fair prices for an asset or financial holding.
The idea of risk-neutral probabilities is often used in pricing derivatives.
The term risk-neutral means an investor would prefer to focus on the potential gains of an
investment rather than the risk attached.
The benefit of this risk-neutral pricing approach is that once the risk-neutral probabilities are
calculated, they can be used to price every asset based on its expected payoff
Calendar Spread
The typical options trade comprises the sale of an option (call or put) with a near-term expiration date,
and the simultaneous purchase of an option (call or put) with a longer-term expiration. Both options are
of the same type and use the same strike price.
The purpose of the trade is to profit from the passage of time and/or an increase in implied volatility in a
directionally neutral strategy.
Since the goal is to profit from time and volatility, the strike price should be as near as possible to the
underlying asset's price.
The trade takes advantage of how near- and long-dated options act when time and volatility change. An
increase in implied volatility, all other things held the same, would have a positive impact on this
strategy because longer-term options are more sensitive to changes in volatility (higher vega). The
caveat is that the two options can and probably will trade at different implied volatilities
Supernormal growth is by definition abnormally high and will not be sustained into the
foreseeable future. Therefore any perpetuity valuation type formula such as P t = d0 × (1 + g)/(r -
g), or Pt = d1 × (r - g), could not be used. Moreover, it is likely that g is greater than r, which
would make nonsense of the formulas. Again, Gordon's approach to estimating the growth rate
is based on assumed regularities which probably do not hold during times of supernormal
growth.
The value of the firm is based on its equity value, i.e. the surplus of assets over liabilities. For a
publicly quoted firm this can be found as the share price times the number of shares
the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in
order to receive one dollar of that company’s earnings.
Generally, a high P/E ratio means that investors are anticipating higher growth in the future.
The P/E ratio can use estimated earnings to get the forward-looking P/E ratio.
Q: What if 2 companies have the same value of P/E ratios, which company does you think is better?
Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and investment
planning to analyze the profitability of a projected investment or project
Q: What is our company’s stock price? How would you forecast the future stock price for next year?
Q: How would you choose to buy a particular stock?
Q: Why might a company choose debt over equity financing?
One of the main advantages of Debt financing is that the promoters do not have to give control over the
ownership of the company.
Equities are riskier. they offer no guarantees, and investors' money is subject to the successes and
failures of private businesses in a fiercely competitive marketplace.
The main decision to go for equity financing or debt financing is maintaining an optimal Debt to Equity
Ratio.
Since equity financing carries a greater risk the cost of equity is greater than the cost of the debt.
Sometimes a company’s most valuable assets are impossible to touch or see. These assets are called
intangible assets and include a company's brand, a loyal customer base, or a corporation's stellar
management team
Working capital is used to drive the day to day operations of the company.
Q: What are deferred taxes
Levered beta measures the risk of a firm with debt and equity in its capital structure to the volatility of
the market. The other type of beta is known as unlevered beta. Unlevering the beta removes any
beneficial or detrimental effects gained by adding debt to the firm's capital structure.
Delta hedging is an options trading strategy that aims to reduce, or hedge, the directional risk
associated with price movements in the underlying asset. The approach uses options to offset the risk to
either a single other option holding or an entire portfolio of holdings.
Put-call parity is a principle that defines the relationship between the price of European put options and
European call options of the same class, that is, with the same underlying asset, strike price, and
expiration date.
C+PV(x)=P+S
C= European Call option, PV(X) = Present value of Strike Price, P= European Put Option, S= Spot price of
the underlying asset
Modified duration: - It is the sensitivity in the changes in the bond portfolio w.r.t interest rate risk.
Duration, in general, measures a bond's or fixed income portfolio's price sensitivity to interest
rate changes.
Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s
price by the its total cash flows, and should not be confused with its maturity.
Modified duration measures the price change in a bond given a 1% change in interest rates.
A fixed income portfolio's duration is computed as the weighted average of individual bond
durations held in the portfolio.
CONVEXITY
6-Mention all the variables involved in Black Scholes and interpret option Greeks?
Spot price – S, Strike Price -X, Risk free rate – r, Implied vols, Delta, Gamma, Theta, Vega, t – Time
duration
7-what is vega, what is delta, what is gamma
Delta is the change in the movement of the option price with 1-unit change in price of the underlying.
Delta > 0.50 it is ITM. Delta < 0.50 it is OTM and delta=0.50 it is ATM.
Gamma – Gamma is the rate of change of delta based on the 1-dollar change in price of the underlying.
Theta is the decrease in the value of the call and put option that it will decrease each day as the option
reaches the expiry date. It is always negative
Vega (Volatility) – Vega is the change in the value of call and put option that will change for every
percent change in the value of implied volatility. It only affects the time value of the option.
8-Derive black Scholes equation of a call option on futures contract and interpret it's meaning. They are
seeing the just approach. Interpretation of black Scholes equation N(d1) and N(d2)?
N(D2) – It tells that the option will be exercised at expiry or the probability that the option will be ITM.
N(D1) – It is the adjustment factor / a normal distribution corresponding to the call option Delta
S N(d1) is the amount that will likely be received on selling the stock at expiration, while the
expression Xe-rT N(d2) is the payment that will likely be made to purchase the stock when the call
option is exercised at expiration. So, the value of the call option depends on the difference between
these two expressions.
9 – What is ATM, ITM , OTM Option and also explain the moneyness of the option ?
Hedge Ratio The hedge ratio compares the amount of a position that is hedged to the entire
position.
The minimum variance hedge ratio helps determine the optimal number of options contracts
needed to hedge a position.
The minimum variance hedge ratio is important in cross-hedging, which aims to minimize the
variance of a position's value.
11- What is protective put / married put?
A protective put, or married put, is a portfolio strategy where an investor buys shares of a stock and,
at the same time, enough put options to cover those shares. In equilibrium this strategy will have the
same net payoff as buying a call option. It is very costly and is not used in practical world.
Bootstrapping
Bootstrapping is building a company from the ground up with nothing but personal savings.
Extremely limited resources can inhibit growth, prevent promotion, and even undermine the
quality of the bootstrapped product.
The bootstrap entrepreneur retains total control of the business and makes all of the decisions.
Forward curves
The forward curve or the future curve is the graphical representation of the relationship between the
price of forward contracts and the time to maturity of the contracts. The vertical axis measures the price
of a forward contract, and the horizontal axis measures the time to maturity of that forward contract.
The forward curve is static in nature and represents the relationship between the price of a forward
contract and the time to maturity of that forward contract at a specific point of time. When the Spot
Rave is upward sloping, the forward curve will be above it, and the par curve will be below it.
The forward curve is a function graph in finance that defines the prices at which a contract for future
delivery or payment can be concluded today. For example, a futures contract forward curve is prices
being plotted as a function of the amount of time between now and the expiry date of the futures
contract
Spot curves
The spot rate Treasury curve is a yield curve constructed using Treasury spot rates rather than
yields.
The actual spot rates for zero-coupon Treasury bonds are connected to form the spot rate
Treasury curve.
In order to value a bond properly, it is good practice to match up and discount each coupon
payment with the corresponding point on the Treasury spot rate curve.
A coupon bond can be thought of as a collection of zero-coupon bonds, where each coupon is a
small zero-coupon bond that matures when the bondholder receives the coupon
A put bond is a debt instrument with an embedded option that gives bondholders the right to
demand early repayment of the principal from the issuer.
The embedded put option acts an incentive for investors to buy a bond that has a lower return.
The put option on the bond can be exercised upon the occurrence of specified events or
conditions or at a certain time or times.
How a Put Bond Works
A bond is a debt instrument that makes periodic interest payments, known as coupons, to investors.
When the bond matures, the investors or lenders receive their principal investment valued at par. It is
cost-effective for bond issuers to issue bonds with lower yields as this reduces their cost of borrowing.
However, to encourage investors to accept a lower yield on a bond, an issuer might embed options that
are advantageous to bond investors. One type of bond that is favourable to investors is the put, or
puttable, bond.
A put bond is a bond with an embedded put option, giving bondholders the right, but not the obligation,
to demand early repayment of the principal from the issuer or a third party acting as an agent for the
issuer. The put option on the bond can be exercised upon the occurrence of specified events or
conditions or at a certain time or times prior to maturity. In effect, bondholders have the option of
"putting" bonds back to the issuer either once during the lifetime of the bond (known as a one-time put
bond) or on several different dates.
Q:-Duration of a zero coupon bond and fixed coupon paying bond, which one would have larger
duration ?
A zero-coupon bond is a bond in which the face value is repaid at the time of maturity. That definition
assumes a positive time value of money. It does not make periodic interest payments or have so-called
coupons, hence the term zero coupon bond. When the bond reaches maturity, its investor receives its par
value
Q:- What is Risk neutral pricing ?
A credit-linked note (CLN) is a financial instrument that allows the issuer to transfer specific
credit risks to credit investors.
A credit default swap is a financial derivative or contract that allows issuers of credit-linked
notes to shift or "swap" their credit risk to another investor.
Issuers of credit-linked notes use them to hedge against the risk of a specific credit event that
could cause them to lose money, such as when a borrower defaults on a loan.
Investors who buy credit-linked notes generally earn a higher yield on the note in return for
accepting exposure to specified credit risks.
Gearing in Finance
Gearing can be thought of as leverage, where it's measured by various leverage ratios, such as
the debt-to-equity (D/E) ratio.
If a company has high leverage ratios, it can be thought of as being highly geared.
The appropriate level of gearing for a company depends on its sector and the degree of leverage
of its corporate peers
Gearing is the phenomenon whereby high fixed cost causes greater volatility of business
outcome. Financial gearing refers to the effect of high fixed financial cost
The strongest justification for the optimal gearing ratio is that it represents the optimal trade-off
between the positive effects of the tax shield and the negative effect of the increasing risk of
financial distress. However, the other factors may also play a role in the trade-off.
Free cash flow to equity is a measure of how much cash is available to the equity shareholders of a
company after all expenses, reinvestment, and debt are paid. FCFE is a measure of equity capital usage.
Where:
Optimal Debt equity ratio is needed to be maintained and if Debt financing is still continued after that
then the WACC will increase.
The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly calculated
as the present value of its future earnings and its underlying assets, and is independent of its capital
structure.
At its most basic level, the theorem argues that, with certain assumptions in place, it is irrelevant
whether a company finances its growth by borrowing, by issuing stock shares, or by reinvesting its
profits.
debt ratio is already this high. You must pay down your debt first.
If your current debt ratio is more than about 20%, you have little choice: With a debt ratio this
high your borrowing power is severely limited. Pay down your debt to below a 20% debt ratio.
If your debt ratio is less than 20% and paying down your debt would mean that you can't make a
20% down payment, keep the cash and make the 20% down payment. Putting 20% down can
get you a better interest rate, make it easier to qualify for the loan, makes for a smaller
mortgage payment, and means you don't have to pay for Private Mortgage Insurance.
If you're not going to be buying for at least a few months, and some of your debt is high-interest
(more than 10% interest, like credit cards), and paying down your debt won't keep you from
putting 20% down on the house, then pay down at least some of your high interest debt. Pay at
GAP Analysis?
A gap analysis is how an organization examines its current performance with its target
performance.
A gap analysis can be useful when companies aren't using their resources, capital, or technology
to their full potential.
By defining the gap, a firm's management team can create a plan of action to move the
organization forward and fill in the performance gaps.
There are four steps to a gap analysis, which are defining organizational goals, benchmarking the
current state, analysing the gap data, and compiling a gap report.
Gap analysis can also be used to assess the difference between rate-sensitive assets and
liabilities
CCAR
The Comprehensive Capital Analysis and Review (CCAR) is an annual exercise by the Federal
Reserve to ensure that institutions have well-defined and forward-looking capital planning
processes that account for their unique risks and sufficient capital to continue operations
Under the rules of the CCAR exam, every mandated bank must submit a “capital action plan” for
the following four quarters. The Fed then assesses that bank's financial health and gives the
bank a score.
Banks file annual CCAR submissions to the Fed, containing projected revenues, losses, reserves
and capital ratios under the supervisory scenarios as well as internally developed idiosyncratic
The Investment Advisers Act of 1940 is a U.S. federal law that defines the role and
Commission (SEC), the act provides the legal groundwork for monitoring those who advise
Volcker Act
The Volcker Rule prohibits banks from using their own accounts for short-term proprietary
instruments. The rule also bars banks, or insured depository institutions, from acquiring or
retaining ownership interests in hedge funds or private equity funds, subject to certain
exemptions. In other words, the rule aims to discourage banks from taking too much risk by
barring them from using their own funds to make these types of investments to increase profits.
The Volcker Rule relies on the premise that these speculative trading activities do not benefit
banks’ customers.
Final enhanced prudential standards (EPS) rules. Banks may already be moving down the path
laid out by the Fed, particularly in the areas of capital planning, stress testing, liquidity risk
management, and risk governance. Although continuing improvements and additional oversight
by the board and senior management will be required, the Fed has already adopted many of
these requirements (in areas such as stress testing) as part of its current supervisory toolkit.
• The final rules are largely consistent with proposed rules issued in December 2011. In fact, the
U.S. top-tier bank holding companies (BHC) have been moving toward these requirements over
the past two years. The final date for implementation is January 1, 2015.
• U.S. BHCs should expect a continued focus on risk governance, distinguishing among roles and
responsibilities across the three lines of defense, and risk analytics, aggregation, and reporting
• Nonbank financial companies were scoped out of the final rules, and the Fed expects to apply
EPS to individual nonbank financial companies by rule or order; however, the requirements
• Single counterparty credit limits (SCCL) will be re-scoped and aligned to international efforts.
They will take into consideration the results of two quantitative impact studies and are expected
rules. • Enhanced risk-based and leverage capital requirements and stress testing requirements
• Liquidity requirements were confirmed including liquidity risk management standards, internal
• Risk management requirements were confirmed and include guidelines on appointing a CRO
and establishing an enterprise-wide risk committee that meets at least quarterly and has at least
• Stress testing requirements explicitly state that the board and senior management are
accountable for consideration of the results of the stress test on capital planning, assessment of
capital adequacy and risk management, and strengthened requirements to publicly disclose
results.
https://www.firmofthefuture.com/content/top-10-differences-between-ifrs-and-gaap-accounting/
Risk Management
serving our customers to the best of our ability and contributing to the development of our
businesses, guaranteeing the Group’s sustainability by implementing an efficient system for risk
analysis, measurement and monitoring
making risk control a differentiating element and a competitiveness factor recognised by all.
This policy is structured around major risk categories likely to affect our results:
credit and counterparty risk, in the event that customers or other counterparties become
unable to meet their financial commitments
market risk, such as significant fluctuations in the prices of securities (equities and bonds) or
commodities
operational risk, related to failures in internal procedures, human error or external events
modelling risk, caused by an inaccurate estimation of the risks at the outset
structural risk: interest rate and exchange rate risk
cash flow and funding risk, in the event that the Group is unable to manage its cash flows
effectively and fund the growth of its business
non-conformity risks, including legal and tax-related risks, and risks related to reputation and
inappropriate conduct
country risk, in the event of changing political and economic conditions in the country of
operation that negatively impact the Group's interests
strategic/business risk, in the event that the Group is unable to implement its strategy and carry
out its business plan;
capital investment risk, in the event of losses resulting from financial participations such as
capital investment transactions
insurance-related risks, in addition to the management of risks related to assets-liabilities, these
also include risks related to the setting of premiums, mortality risk and increased cost of claims
risk of residual value related to specialised financial services;
risks related to climate change are considered to be compounding factors for the risks already
faced by the Group
Specifically, the main objectives of the Group’s risk management strategy are: